To attract new talent, motivate employees and executives, and reward high performers for results, banks often implement equity-based compensation plans. Among the most popular types of equity-based compensation plans are incentive stock options, nonqualified stock options, and restricted stock. Overall, each of these plans has a positive impact, but choosing the one that's right for your institution depends on factors unique to your institution and the employees you are rewarding, including understanding the related tax treatment.
Nonqualified stock options
When a nonqualified stock option is exercised, the amount by which the fair market value of the stock at the time of exercise exceeds the exercise price (the “spread”) is reported as taxable wages. For the employee, the spread is subject to federal income tax in the year of exercise. After exercise, the employee owns the shares and the shares can be sold at any time. Upon the sale of the shares, any gain recognized during the period the shares are held will be treated as a capital gain (or loss, if sold at a loss) for income tax purposes.
Bank tax impact: The institution receives a federal income tax deduction at the time of exercise for the spread that the employee includes in personal taxable income.
Incentive stock options
Incentive stock options (ISOs) are generally preferred by eligible employees since ISOs aren't included in employees’ wages for income tax purposes at the time of exercise, unless a disqualifying disposition occurs as later discussed.
- There are quite a few restrictions for an option to be considered an ISO, including meeting all of the following criteria (and certain other criteria):
- ISOs must be granted by a plan that specifies the number of shares to be issued on exercise of the options and the classes of employees eligible to receive the options.
- The plan must be approved by shareholders within 12 months before or after its adoption.
- Options must be granted within 10 years after the earlier of the adoption of the plan or the date of shareholder approval.
- Generally, options cannot be granted to an individual owning more than 10 percent of the combined voting power (there are limited exceptions to this).
- The exercise period is generally limited to 10 years after grant.
- Terms of the option must specify that it is not transferable to any person other than the employee during their lifetime.
While the exercise of ISOs does not result in taxable wages to the employee, the exercise may result in an alternative minimum tax impact to the employee. It’s important for your employees to review their individual tax position at the time ISOs are exercised.
Bank tax impact: The institution does not receive the federal income tax deduction for the spread when ISOs are exercised. However, if a disqualifying disposition occurs, the institution receives the tax deduction at the time of the disqualifying disposition.
Restricted stock is taxed differently than stock options. Restricted stock generally becomes taxable upon vesting. When a share of restricted stock becomes vested, it is included in the employee's ordinary income in the year of vesting.
Since restricted stock generally does not involve the employee paying an exercise price, the employee will have compensation in the amount equal to the fair market value of the stock at the vesting date.
Section 83(b) election
A holder of restricted stock has the option to make an 83(b) election at the time of grant. If this election is made, the employee reports the fair market value of their shares as ordinary income on the date they are granted, instead of waiting until they vest. Making this election offers two potential benefits:
- Paying tax based on the fair market value of the stock at the grant date rather than the vesting date, which would result in a lower tax bill assuming the fair market value increases between the grant and vesting date
- The holding period for long-term capital gain treatment begins at the time of grant rather than the time of vesting
On the surface, making the election sounds like an easy decision given the benefits, but there also is some risk. If the employee leaves the institution before the restricted stock vests, all rights to the stock are forfeited, and the employee won't be able to recover the tax paid as a result of the election.
Bank tax impact: The institution receives a deduction for the amount the employee is including in income at the same time the employee has the taxable event. Without an 83(b) election, the institution receives a deduction for the fair market value of the stock at the time of vesting. If an 83(b) election is made, the institution receives a deduction at the grant date for the fair market value at the date of grant.
Equity-based compensation plans can support the growth of your bank by helping you recruit, retain, and motivate top talent over the long run, but it's important to choose a plan that makes sense for your institution. That means carefully considering your specific objectives and the tax impact of any incentive program you put in place.